Unarguably, Nigeria’s robust demographics, with an
estimated population size of 197.0m people accounting for 18.3% of Sub-Saharan
African population, remains a strong fundamental attraction to the FMCG sector.
Since the crash of global oil prices in H2:2014 culminated in economic
recession, the Nigerian consumer market is yet to recover from enormous
adjustments in spending pattern despite the subsequent recovery witnessed in
Q2:2017. FMCG companies in our coverage universe produce mostly necessity goods
(flour, sugar, salt, beverages and personal care). Nigeria’s forex challenges,
between 2014 and 2017 which climaxed in the ban of 41 items in 2015, elevated
the vulnerabilities of the sector. However, the introduction of the Investor
and Exporters’ (I&E) FX window in April 2017 provided succor. Post-I&E,
calm is returning in access to forex although currency depreciation triggered
higher cost of production which is being effectively passed through prices to
final consumers, despite stiff competition.

Nigeria’s FMCG industry remains fundamentally
attractive to investors across borders. Our coverage universe has counters that
are favoured by local and foreign institutional investors. Disaggregating
valuation across sub-sectors shows clear case of undervaluation and presents
compelling opportunities for upside. Our comparison of average valuation
metrics across flour milling companies in Africa (11.0x) shows undervaluation
of Nigeria’s flour milling industry (4.1x). Similarly, average price to
earnings (P/E) ratio of Sugar (Africa:14.5x; Nigeria: 6.0x), salt
(Africa:29.5x; Nigeria: 9.9x) and personal care (Africa: 25.5x; Nigeria: 25.4x)
are higher for African peers than those of their Nigerian counterparts.
However, the beverage sector (28.7x) appears fully priced in Nigeria relative
to the average pricing in Africa (18.2x).

Our intrinsic valuation perspectives viz a viz the
readings of sentiment suggest market pricing will likely pick up post-2019
elections wind-up. We also anticipate the FY:2018 earnings to prop investor
sentiment. On a fundamental basis, our valuation models show elevated cost of
equity across securities, based on higher risk-free rate and risk premiums. We
assumed conservative sustainable growth rates across companies. Of the 8
securities covered, we have “BUY” recommendations on two, “ACUMULATE” on two,
“HOLD” on one “REDUCE” on one and “SELL” rating on two.

Against the perceived long-term 15-year average growth
rate of 7.6% (2000-2014), the reality of Nigeria’s fiscal vulnerabilities
crystalized in a 2-year (2017-2018) average GDP expansion of 1.4% post-2016
recession. Worse still, the economy remains laden with weak per capita income
estimated at US$1,800 – relative to low income countries’ average of US$750.4 –
as at the end of 2017.

Demand remains tepid despite intact consumer appetite.
Weak income levels have necessitated painful adjustments that resulted in
negative consequences on aggregate volume. Higher prices and aggravated general
price levels have also constrained consumer spending power; discretionary
incomes have shrunk though tax rate remains the same. Real income per-capita
has fallen to US$974.3 (estimated) in 2018 from as high as US$1,881.4 in 2014.
Consumer Confidence Index (CCI) also remained weak since 2016 though gradual
recovery is becoming noticeable.

Notwithstanding, sector investment has been
commendable in line with the enormous potential for growth given the compelling
demographic configuration which places Nigeria as the largest consumer market
in Sub-Saharan Africa. From our sector coverage estimates, average Capital
Expenditure (capex) rose Y-o-Y by 151.4% in 2018 to N57.0bn from the 58.3%
decline suffered in 2017 (N22.7bn). We expect tepid growth in capex for 2019
until income levels recover to prop demand. Industry appears to be optimal on
capacity especially given the weak demand; investments in cost efficiency
remains needed to optimize value for investors.

Between 2015 and our 2018 estimates, finance charges
of players in our coverage universe grew from N33.0bn to N68.8bn. Overall,
capital mix appears skewed towards debt than equity over the four-year period.
In our view, the reality of debt burden going forward may shift focus to equity
financing sources in our forecast period as we expect favourable market
conditions to make equity financing options more compelling.

Beverage:
Weak consumer spending power has constituted a drag to volume growth in real
terms; however, higher prices that were effectively passed through to consumers
made up for revenue, which on the average grew at a CAGR of 17.0% over 5 years.

Flour Milling: For the three flour millers – FLOURMILL, DANGFLOUR and HONYFLOUR – in
our universe; direct cost burden was a common factor to all with an average
industry cost to sales ratio of 79.4% in 2018 and a 5-year average median and
high of 82.2% and 87.8% respectively. Although higher prices of wheat continue
to eat into margins of players, industry efforts towards backward integrating
are still preliminary. We believe revenues will remain stable for players as
bread and other wheat derivative meals are still major staple foods in Nigeria.
Although volume may contract as consumer income level continues to struggle
amid weak economic prospects, higher prices, given the inelasticity of the
products, will support revenues. We estimated 4-year revenue CAGR of 14.0% as
at FY:2018 while we project a flattish revenue growth of -0.2% in 2019
financial year.

Sugar:
The sugar market in Nigeria is growing very fast especially for industrial
usage. The three biggest players – DANGSUGAR (1.44MMT), BUA SUGAR (1.44MMT) and
GOLDEN SUGAR (0.85MMT) - all have total installed capacity of 3.73MMT per
annum. The backward integration story has been most successful for the sugar
industry as all the 3 biggest players have keyed into it in line with the
National Sugar Master Plan (NSMP) rolled out by National Sugar Development
Council (NSDC). We project a stable output increase in 2019 but gradually
expect increasingly tepid growth over our forecast period at a CAGR of 1.7%.

Personal Care: PZ and UNILEVER are the corporates in our personal care industry
universe. The sector has been dragged majorly by weak consumer spending. Given
the nature of goods, product innovation and branding have been the bases of
competition amongst players. Over a 5-year period, revenue grew at a CAGR of
8.3% with estimated growth rate of 4.9% in 2018 while 2019 is forecast to grow
marginally by 0.5%.

In our coverage universe, revenue grew on a CAGR of
14.8% over a 4-year period with an estimated 2.7% decline in 2018. Sales growth
remains strong across segments despite the noticeable trends on weaker volumes
since 2015 as depressed consumer spending power is yet to recover. Internal
efficiencies and effective cost pass through aided the OPEX margin which on the
average moderated from a high of 16.2% in 2014 to an estimated 10.4% in 2018.
As a result, average growth in EBITDA settled at 21.2% (10.0% estimates for
2018) over the period, with margin rising from 11.0% in 2014 to 15.3% in 2017.
This is estimated to further rise to 17.3% in 2018. Profitability metrics
improved as PBT and PAT grew at a CAGR of 21.5% and 20.8% while PBT and PAT
margins are estimated at 13.4% and 9.4% in 2018 relative to prior 5-year
averages of 7.8% and 5.9% respectively.

Dupont analysis of the FMCG sector shows that the
sector’s return on equity (ROE) has been mainly driven by higher leverage and
somewhat efficient asset turnover ratio. Beverage industry, NESTLE, remains
efficient in sweating assets though leverage is also higher to produce a higher
ROE. Flour milling companies’ ROEs are also driven by higher leverage and
efficient asset turnover ratios while the same applies to the personal care
industry, sugar and salt industries in our coverage universe. Overall, average
ROE (28.0%) is being achieved at an average net margin of 11.7%, financial
leverage of 2.9x and asset turnover ratio of 0.9x.